PM May's speech has signalled a shift towards an ‘economically rational’ Brexit. This can only be good news for a significantly undervalued currency
Theresa May’s speech in Florence has signalled a shift in the UK’s position towards an ‘economically rational’ Brexit – one that seeks to reduce some of the medium-term UK economic uncertainty clouding sterling markets. This can only be good news for a significantly undervalued currency – though any upside potential may be less imminent and obvious at this stage.
While prospects of a two-year transitional period pose upside risks to our year-end GBP/USD and EUR/GBP forecasts of 1.33 and 0.90 respectively, we are reluctant to revise these until we see greater strides towards a deal. Michel Barnier’s response to the speech suggests this could be one of the focal points of Brexit talks over the coming weeks and months – and therefore we still retain a constructive GBP outlook in the near-term.
The knee-jerk move lower in GBP suggests investors may have been hoping for a clearer and more succinct speech from the Prime Minister, rather than the one they got. In effect, it takes us to the same destination: the UK will be looking for a two-year status-quo transition deal with EU once the Article 50 period transpires in April 2019.
An agreed transitional period, in principle, could unlock further upside potential in the pound, but our economists wary that getting to that stage may not be a straightforward path. The response from the EU’s chief Brexit negotiator, Michel Barnier was fairly amicable, but he noted a transition deal is subject to “the wishes” of the EU. While they have previously supported the idea of a status-quo transitional arrangement, the finer details – such as the exact budgetary and judiciary conditions of any transition period – still need to be ironed out.
If this two-year transition deal can be signed, sealed and delivered swiftly – then we see three channels which could make the GBP move higher:
(1) reinforced BoE policy tightening sentiment and a steeper UK rate curve
(2) a recovery in domestic investment prompting upside risks to the UK's growth outlook
(3) a reduction in GBP downside tail risks stemming from cliff-edge Brexit risks being pushed further down the road
A combination of these factors would inject some modest upside to pound over the coming months, with GBP/USD potentially moving up to 1.38-1.40 by year-end. Equally, we could see EUR/GBP trade in a slightly lower range of 0.85-0.87 on the basis of a swift transition deal.